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Dealing With Franchise Sales Violations

There are no easy answers when a violation of the franchise sales laws occurs. The better approach is to encourage franchisors to implement and support effective sales compliance programs designed to prevent violations and serve as an early warning system when mistakes happen.

By Richard Morey, CFE and Ann Hurwitz, CFE

The previous articles in this series on franchise sales compliance have examined the value of complying with the franchise sales laws, the elements of an effective franchise sales compliance program, and the implementation of systems to promote legal compliance in the franchise sales process. In this final article we consider how a franchisor might deal with potential franchise sales violations.

Mistakes at various stages of the franchise sales process can lead to violations of the franchise sales laws. The Franchise Disclosure Document may not be delivered within the time period required by federal and/or state franchise laws. Failure to track or communicate the company’s status in the franchise registration states may lead to an offer or sale at a time when the company is not properly registered or exempt in a state that requires registration. And there is always the possibility that a representative of the company may inadvertently make an unauthorized financial performance representation -- a possibility that is arguably greater if the company does not make a financial performance representation in Item 19 of the FDD.

Franchise sales violations can have profound legal consequences

Violations may trigger governmental enforcement actions, including state-imposed offers of rescission to those franchisees who purchased a franchise affected by the violation. Private rights of action for damages or rescission under state franchise registration laws, business opportunity laws or “Little FTC” acts and common law claims of fraud or misrepresentation are also common. These actions not only may require a company to pay large amounts to defend and settle the claim or satisfy a judgment for damages, they are also a distraction from the day-to-day business of the company. In addition, these actions may result in negative disclosures that must be included in the FDD for years after the matter has been finally resolved.

In addition to direct legal consequences, franchise sales violations also have important practical consequences. If the sales violation is discovered before the sale is completed, the violation may so taint a particular transaction that the franchisor determines it cannot safely move forward with the prospect. Violations of state franchise registration laws may delay state registrations. And significant or recurring sales violations may negatively affect a brand’s valuation on a sale of the franchisor or the franchisor’s efforts to obtain debt financing. Importantly, a franchisor’s knowledge of one or more franchise sales violations may have a chilling effect on its approach to enforcement, with negative consequences for system standards and the brand’s competitive standing.

Compliance processes important

For all of these reasons and others, a good compliance program will include processes to identify and correct potential franchise sales violations at the earliest possible stage. Processes that are often implemented prior to closing the franchise sale include the following:

Timely collection and review of FDD Receipt pages to ensure that they have been properly signed and dated and that all franchise sellers are correctly listed on the receipt page. If an error in signing or dating the receipt page is discovered before closing, it will be easier to correct the error so that the signed page accurately reflects the FDD delivery date and the name (and title) of the person who received the disclosure, substantiating that the FDD was delivered within the time period required by law.

Pre-closing verification that the franchise was properly registered (or exempt from registration) in all applicable franchise registration states at the time of the offer and that those registrations (or exemptions) will be in effect on the anticipated closing date. Violations of the state franchise registration laws are among the most serious of the franchise sales violations and among the most challenging to correct after the fact. Care in monitoring, communicating and confirming the company’s registration status in all applicable registration states prior to sale is critical.

Completion by the prospective franchisee of a “Summary of Acknowledgements” designed to elicit information that may reveal any inadvertent sales violations. The summary should be reviewed by a compliance officer of the franchisor prior to the anticipated closing date to determine whether there are any “red flags.” It is important to recognize that the appearance of a red flag is not necessarily fatal to the sale. It may simply require further investigation to develop the facts and determine that no violation exists. However, if a possible violation is indicated, it is far better to address the issue before closing.

Post-sale violations heighten risks

Franchise sales violations that are discovered only after closing are more challenging to address. As an initial matter, the franchise company must decide whether to take a proactive or defensive approach to the violation.

If it is a non-recurring technical violation, a franchisor may decide to do nothing and allow the applicable statute of limitations to run. Such an approach comes with inherent risks, including the risk that the violation will be discovered by the franchisee or others -- perhaps after several months or years of damages have accumulated. In addition, the fear that the franchisee may discover the violation often makes a franchisor reluctant to enforce the franchise agreement or require the adoption of changes that benefit the system.

A proactive approach to the violation also carries risks. Disclosing the violation to the affected franchisee and any applicable state regulatory agency may result in a legal claim by the franchisee and an enforcement action by the state agency, which may include a requirement to offer rescission to the franchisee. But proactively bringing a violation to the attention of the state with the goal of resolving it often will result in settlement terms more favorable to the franchisor than if the state discovered the violation on its own initiative or if it is later discovered by the franchisee and reported to the state. Moreover, if the franchisee is satisfied with the investment and declines the rescission offer, the franchisor is no longer “hostage” to the past violation and its legal position is vastly improved if the matter is raised again at a later date.

Effective compliance programs best

There are no easy answers when a violation of the franchise sales laws occurs. The better approach, and the objective of this series of articles and IFA’s FranGuard program, is to encourage franchisors to implement and support effective franchise sales compliance programs that are designed to prevent such violations and to serve as an early warning system when mistakes happen. Doing so protects the franchisor by minimizing compliance problems and costs, protects franchisees by ensuring they have complete information on which to make their investment decisions, and protects franchising in general by continuing the process of self-policing and self-correction that has helped further the explosive growth of the franchise model for decades.

Richard Morey, CFE, is a partner at DLA Piper in its Chicago office. Ann Hurwitz, CFE, is a partner at Baker & McKenzie in its Dallas office.

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